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Overcoming Commodity Prices with Private Labels

Tue, 07/26/2011 - 12:31pm
BRIAN BOYLE, Senior Managing Director, Food & Beverage Group, McGladrey Capital Markets LLC

McGladrey CapitalWithout question, the rise of commodity prices has a direct impact upon food manufacturers. Most noticeable is the impact they have on gross margins. When food manufacturers sell through retail or commercial food service channels, there is typically a lag time between the fluctuation itself and the time when a manufacturer can adjust its prices towards the retailer to offset those changes. Retailers typically want a minimum of a three- to six-month commitment to their existing pricing before making changes.

Inherent volatility in commodities (wheat, corn, grain, sugar, etc.) makes it difficult for food manufacturers to manage their business, while still maintaining their margins.  Sometimes it works in their favor, however.

For example, in early 2008, commodity prices were very high — and had been since the spring of 2007 — so food manufacturers were able to raise prices. Then, when the financial crisis hit and the attending commodity markets were affected, causing a drop, the lag benefited them because their margins actually increased.

But more often than not, the realities are that a rising and fluctuating commodity market impacts the margins of the food manufacturing industry negatively as a whole. The Chairman and CEO of General Mills, Ken Powell, recently noted, “This past year represented a challenging operating environment for food manufacturers, as we experienced the return and rapid acceleration of cost inflation for various food ingredients and energy.”

For private label manufacturers, rising commodity costs can have an even more significant impact than brand label producers. Typically, private label products are sold at a 25 to 30 percent discount compared to the national brands. National brands essentially set the prices in the market, leaving private label companies somewhat hostage to the competitive pricing of national brands, due to their high visibility and recognition.

Of course, national brands have their own costs — marketing and slotting costs, for example — which is why they have the higher cost premium in the first place, compared to private label manufacturers. But by and large, since they have little control over pricing, private label manufacturers are especially susceptible to margin hits taken during a rising commodity price period.

What can private label manufacturers do to mitigate this?

There are a few ways to address this challenge. First, private label manufacturers can "hedge" their commodity risk using derivatives such as financial futures, options and swaps. They can "buy forward" and lock in commodity prices if they believe that the prices are going to rise, or choose not to do so if they believe that the prices are trending downward.

Second, for private label manufacturers, differentiation in the marketplace is a particularly effective approach. Consumers have demonstrated a willingness to pay for products that satisfy a unique need or embrace a growing trend. This gives companies a bit more latitude in passing along commodity price increases that will likely be more readily accepted by the specialty consumer.

Research and development is critical to all food processors, be they branded or private label manufacturers. By developing unique products that address the growing trends in the marketplace, companies can mitigate some of the inherent risks associated with volatility in commodities market, as well as a better hedge against the influence of major label manufacturers.

Some examples of current trends in food manufacturing include the natural, healthy and organic movement. Over time, this has proven to be a megatrend, not merely a "fad,” with more products coming out every day that address the health conscious consumer:  Low carb, low fat, all natural, organic, gluten free are examples.

Another example is ethnic brands, a category that is doing well and currently on the rise.  Ten years ago, it was Mexican and Asian. Today, it has expanded into Mediterranean, Indian, Caribbean and others, providing opportunities for a host of niche products to meet that trend.

Consumers have historically demonstrated a willingness to pay for a differentiated product. Starbucks Coffee is a prime example of this. Fifteen years ago, coffee was a commodity — it was 50 cents a cup. But through product development, marketing and branding, it evolved into a trendy category and consumers routinely pay $4 for their mocha cappuccino. Another example is bread; years ago, bread was 99 cents a loaf and limited to a few brands. Today, consumers pay a premium for a wide variety of artisan and specialty breads, and companies which cater to this niche, such as Panera, have done well.

Do not miss the opportunities for taking advantage of multiple niches within a specialty.  For example, an Indian food product could also be marketed towards health-conscious vegetarians. An artisan bread product could also be used to market towards those who are looking for whole grains and gluten-free options. One secret to survivability in these challenging times is to keep abreast of trends and seek to fulfill those needs in a niche that no one else is currently or effectively meeting.

Boyle has 23 years of capital markets experience and currently runs the firm’s Chicago office. He has successfully negotiated and completed nearly 75 sale and recapitalization transactions in a variety of industries, including food and beverage, business services, healthcare and industrial manufacturing. For more information, please visit www.mcgladreycm.com.

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